Getting the hang of holiday shopping

Commentary: Net 'fatigue,' unusual VC funding, more

By

SageBrennan

SHANGHAI (MarketWatch) -- Gearing up for a holiday season that will pass almost without notice in China, investors will not see the economic pop here that Western countries typically see.

But holidays of all sorts, especially the Lunar New Year at the end of January, are increasingly accepted with enthusiasm in shopping-crazy cities like Shanghai. The main streets of China's first-tier cities reflect the purely commercial aspects of the Western holidays, manifested in the neon lights, plastic Christmas trees and the red felt reindeer antlers on the heads of Starbucks baristas.

Roughly 3,000 players of China's top online game, The9's
NCTY, -7.18%
World of Warcraft, declared that they will stop playing the game because The9 activated a "fatigue system" on their server group. This represents a relatively rare instance of the system, which regulators have designed to limit play to three hours per user in an effort to combat so-called "Internet addiction," actually affecting gamers' activity. Nonetheless, investors can expect The9 and competitors in the online game sector, such as Shanda Interactive Entertainment
SNDA
Netease.com Inc.
NTES, -4.09%
and Tencent, to begin to look for ways around the restrictions of the fatigue system.

The9 last week announced that it has licensed the Soul of the Ultimate Nation from Korean game developer Webzen
WZEN
which adds another proven title to the company's pipeline, even though gamers will not see a trial version until late 2006.

Intellectual property violations, small and smaller

A blogger at Pacific Epoch noticed last week that popular student-oriented social networking website The Facebook.com, which recently raised $13 million from Accel Partners, has been blatantly copied by a Chinese Web site, right down to the graphics on the homepage. This is a relatively extreme example of the copy-to-China phenomenon, in which a successful business model is slightly adapted and launched in China. Many of the more subtle copy-to-China models have of course become very successful companies, such as Baidu.com Inc.
BIDU, -0.05%
and even the early China portals -- thankfully no longer called "chortals" - Netease.com Inc., Sina Corp.
SINA, +0.44%
and Sohu.com Inc.
SOHU, -2.70%

Also on the intellectual property beat, wireless value-added services provider Kongzhong Holdings
KONG
was recently found guilty of offering several music tracks in its "color ring-back tone" service without permission. Music publisher Bird Man was awarded just under $40,000 in damages in the ruling. Investors should see cases like this one, though very small, gradually become more common as understanding of the legal issues surrounding intellectual property grows more widespread in China.

Chatea raises unconventional funding

Much has been made of recent increases in high-yield lending to take up the slack that resulted when domestic banks began to tighten credit. But China's booming private sector is looking to a variety of mechanisms to finance growth. As an example of the increasingly creative deals that China's private equity sector is likely to see in the coming year, I offer up the unique funding of Shanghai-based restaurant chain Chatea (Yi Cha Yi Zuo) by several investors known for deals in completely unassociated industries.

IDG Technology Venture Investment, one of China's best-known backers of successful early-stage technology companies like Baidu, Sohu.com Inc, eBay's Eachnet and Ctrip
CTRP, +1.68%
as well as a large number of promising startups, was a surprising participant in the financing of Chatea's privatization, joining Susquehanna International Group.

The $7 million round, closed in early December, privatized the 70% share of the company that had been owned by the Shanghai government, which reportedly made a 30% return in the roughly one year that it owned its share of Chatea.

Is this an example of the influence of the Shanghai government in private enterprise? Sure, but it also is a recognition that a solid business concept deserves attention - even from unexpected quarters. Investors known for whiz-bang technology investments out on the Long Tail were willing to bet on a decidedly old-economy business model and management team, which hails from the China divisions of McDonald's Corporation
MCD, +0.48%
Yum Brands Inc.'s
YUM, +0.46%
KFC and the original Taiwanese founders.

So why is this a venture capital deal? Chatea emphasizes a commitment to providing a high-quality customer experience, which diners in the West, for the most part, take for granted. In China, restaurant customers are treated unevenly, at best. So an operation that keeps customer service as a mantra and provides a stylish atmosphere has a real chance to grow quickly if it is adequately capitalized, much as Starbucks
SBUX, +0.33%
has in China. In this concept, the investors apparently see the potential for VC-like returns.

One of the most interesting aspects of Chatea is that with 17 restaurants, several of which are located in cities as far as Beijing, the company has developed a scalable model to produce food of consistent quality from a single kitchen in Shanghai, similar to the McDonald's model, but with a stylish twist. Chatea claims that the kitchen can support up to 60 restaurants. Customers, in general, have no idea that the gleaming kitchens featured in every location do not actually produce any of the dishes that are served. They also have only a vague notion of the massive margins that Chatea makes on the gourmet teas it sells.

Will we see more deals like this one? Probably not exactly, but compelling deals that can clearly be pulled off with a bit of creativity abound in China.

Sage Brennan is general manager of Pacific Epoch, which covers China's emerging media, entertainment and technology industries. He does not hold positions in any of the companies covered in this report. E-mail him at sage.brennan@pacificepoch.com.

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